Research.LeutholdGroup

If uncertainty is the bane of investors everywhere, then the fear of large losses in a bear market is the boogeyman hiding in the closet. The threat of an agonizing downturn often leads investors to carry lower equity weights in their balanced portfolios than might be advisable, and even drives them to hold excess cash to avoid the risk of sizable declines.

ETF families have responded to this anxiety with a fund design that takes some downside risk off the table and may enable investors to tiptoe into equities even when they suspect a selloff might be around the corner. Known as “buffer”, “defined outcome”, or “target outcome” funds, these ETFs utilize an options collar overlay to trim the upside and downside tails of the underlying asset’s return distribution, thereby giving nervous investors a more comfortable way to pick up some equity exposure during riskier times.

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Option collar strategies provide a defined outcome on the date of maturity, but the value from inception to maturity varies. In the case of an extreme market move either direction, a collar strategy will not capture the fullness of the fluctuation early in its lifecycle, but should reach its cap/floor value as maturity nears.

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Despite skyrocketing investor enthusiasm, buy-write strategies are complicated investments with skewed payoff structures that muddle the interpretation of past performance, because returns depend on market conditions.

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Many investors appreciate the benefit of covered-call strategies, but we wonder how many truly understand the opportunity costs of buy-write funds over time—or under differing conditions. On the surface, these approaches are simple, but they have complicated payoff patterns relative to stock and bond funds.

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After years of wandering in the wilderness, Japanese stocks are leading the world’s developed markets higher in what has been a robust opening half of the year. The table shows Japan leading the world’s ten largest developed markets (as measured by the MSCI family of international indexes) with a 24% local currency return through June, easily outpacing the pack. Even as the MSCI USA index gained 17% by successfully “fighting the Fed” this year, Japan surged another 7% beyond that outstanding result.  We were curious to understand the nature of Japan’s spectacular run in 2023, looking to identify the drivers of this strong and relatively quick jump higher.

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After being ignored for a generation, Japanese stocks are roaring in 2023. The Nikkei puts the S&P 500’s 16.9% YTD gain to shame with its +28.7% return. With developed international equities (ex-Japan) up a paltry 9.5%, diversification from expensive U.S. stocks cannot fully explain Japan’s surge.

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The Fed’s June announcement of a pause with further rate hikes to come has extended the uncertainty of whether an inverted curve and persistent policy tightening will ultimately lead to a recession. The business cycle is a critical investment issue because the relative returns of many assets depend on the state of the macro economy. This study examines the Consumer Discretionary (CD) sector’s behavior in recessionary times, with the goal of understanding the typical performance pattern during economic lows in order to help investors position their portfolios for a potential recession.

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While sentiment on the potential for a recession by year-end is split, there is little dispute that it’s an important question for cyclical sectors. Consumer Discretionary is most exposed to the business cycle, and we are interested in understanding its prospects as we head toward a potential economic slowdown.

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The S&P 500 posted a 7.7% price gain for the six months ended April 30^th, although this advance has been a hard-fought battle as gains have resulted from a narrow list of drivers. Style leadership has been concentrated in mega-cap tech names, such that the ten members of the NYSE FANG+^® Index have produced 77% of the S&P 500’s YTD gain. Furthermore, gains over recent months have resulted solely from expanding multiples. Narrowness in either thematic leadership or price drivers is concerning because breadth is a useful concept in evaluating the staying power of a market advance. In light of this year’s market action, we are intrigued by the notion of measuring breadth not simply by price moves alone but by examining each of these two important sub-components individually. Does today’s environment, where price gains are driven by valuation increases alone, tell us anything about future market returns?

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The S&P 500 posted an encouraging +9.2% YTD, but below the surface that strong return was the result of a limited number of influences. There is narrowness in both thematic and return drivers; the fact that gains have not been broad-based is cause for concern about performance during the remainder of 2023.

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A distinguishing feature of fixed income securities is that the expected return on a bond over its remaining lifetime is known with considerable certainty at the time of purchase. This characteristic can be a blessing or a curse, the negative aspect coming into play during an asset price bubble. Equity investors can justify almost any price as they dream of boundless riches arising from the bubble’s driving theme, limited only by their imagination. However, a bond’s yield to maturity is known at the time of purchase and this is the return investors in aggregate will earn. Even during the euphoria of an asset bubble, the expected outcome - the return of par value at maturity - is also the best-case outcome, and that is where our story begins.

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Here we evaluate the returns of fixed-income ETFs since the Fed began its boosting campaign last March; for many mainstream offerings, the picture is not a pretty one. We recap the pain felt by investors in conventional fixed-rate bond funds.

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One of the most vivid memories of the Great Depression is the sight of nervous depositors lined up outside a bank hoping to withdraw their meager savings before the bank failed.  Like a rare tropical disease that was thought to be eradicated by modern medicine, the classic bank run reappeared this month in the form of Silicon Valley Bank.  At the beginning of March, the market had no particular concerns about the potential for systemic bank failures, but SVB’s sudden demise has cast a pall over the entire industry.

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Style investors recently witnessed a rare event when, on February 13^th, the P/E ratio of the S&P 500 Growth Index fell below that of the S&P 500 Value Index. At first glance, it is tempting to attribute this valuation flip-flop to the 2022 bear market, which saw Value outperform Growth by a whopping 24.2%. However, the bear-induced collapse of Growth stock prices in 2022 only served to return the P/E spread to a level just below its historical median of 5.1, meaning that the final move toward parity was caused by a force outside the market itself. That “something else” was the S&P 500 style reconstitution that occurs annually on the third Friday of December.

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S&P rebalanced its style indexes in December, and the shuffle caused substantial turnover. The Value index now includes a sizeable swath of mega-cap tech companies, and this changing membership significantly affects the relative valuation metrics that defined those styles.

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One of the societal benefits of recessions and bear markets is that they serve to correct the unhealthy excesses that build up in overheated economic booms and overly enthusiastic bull markets. As market historians, we believe it is instructive to look back at cycles of excesses and their corrections to learn how such patterns evolve and, quite often, repeat themselves.

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The fourth quarter of 2022 saw broadly positive equity-market performance with the S&P 500 returning +7.6%, the Russell 1000 Mid Cap Index at +7.2%, and the Russell 2000 Small Cap Index gaining 6.2%. Strong returns usually present a headwind for active managers, but the fourth quarter proved productive for actively managed funds.

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Deflating valuations in the Technology and Innovation space produced ghastly results for growth investors in 2022, with the S&P 500 Growth index experiencing an agonizing 29.4% loss. Meanwhile, last year’s bear market was no more than a mild irritation for value investors as the S&P 500 Value index lost just 5.2%. The collapse in exuberantly priced growth stocks produced a 24.2% return spread between the value and growth styles, which goes into the record books as the second biggest annual win for value since 1975.

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Style rotation powered S&P 500 Value to a 24.2% advantage vs. Growth, while DM large-cap Value earned a 20% return spread against Growth. Small-cap spreads favoring Value were also in the double-digits, but narrower because small-cap Growth wasn’t exposed to the collapse of mega-cap Tech. 

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The 2022 bear market will be remembered as a year when collapsing growth stock valuations and rising interest rates doomed almost every asset class to return purgatory. Hopes for avoiding a second down year rest with a potential top in interest rates and solid earnings underpinning the stock market. Wall Street strategists have a year-end 2023 price target of just over 4,000 for the S&P 500, a few percentage points of upside from today but hardly reason to toast a prosperous new year.

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